By Nicholas Pratt

Competition, talent and technology – What’s propelling change in the FX Prime of Prime Brokerage Market?

October 2021 in Special Reports

Over the past year, competition has been increasing across the global FX Prime of Prime (PoP) market, driven largely by PoPs looking to expand market share and position themselves to benefit from the recent growth among retail trading venues. The Covid-19 pandemic has seen a sharp rise in retail trading volumes with traders able to spend more time focusing on the markets.

At the same time, says James Alexander, CCO at Invast Global, a multi-asset PoP, the retail brokers that serve the retail audience have been slashing visible trade costs. As a result, volumes executed through online trading venues has increased sharply over the last 18 months – benefiting the brokers that serve this audience and increasing demand for credit from the PoPs that serve a large proportion of the retail venues.

“This demand for credit is a big driver of the competition we are seeing amongst PoPs, with some struggling to serve the ever-growing needs of their clients,” says Alexander.

Significant competition

While there is significant competition amongst PoPs, there is also a stratification within the sector, says Alexander. This phenomenon involves larger, more established PoPs, stepping into a more ‘prime broker’ like role, with smaller PoP operations then fulfilling the needs of smaller, niche customers. “Invast Global is benefiting from the stratification among PoPs, enjoying a strong balance sheet and access to multiple Tier 1 Prime broker relationships,” says Alexander. “Today, prime brokers – particularly in the light of the Archegos hedge fund demise – are rightly being selective with their choice of counterparties. They are however seeing an increasingly rewarding engagement with larger PoPs whose businesses continue to expand and through whom they can access volumes they may wish to contract with directly.”

Currently, the range of PoP solutions is broader than ever before, and this has been a big driver of the aforementioned stratification. In particular, there is an increasing focus on multi-asset capability, says Alexander. “Many PoPs have traditionally been focused only on FX and have such built relationships and client solutions that cater to this asset class only. Over the last 18 months, an evolving appetite has been observed amongst retail trading venues for access to equities and futures and their over-the-counter (OTC) equivalents. As a result, PoPs are now required to deliver a genuinely multi-asset solution to those same retail venues. This diversification of offering is important not only to meet the demand of retail trading venues, but to further diversify counterparty risk with the prime brokers that serve the PoPs themselves,” says Alexander.

“It has been a very positive year for the PoP segment and as we move into a landscape where interest rates rise above zero globally, heightened volatility should continue to be a positive driver for PoPs,”

James Alexander

While there is strong demand for truly multi-asset solutions and accommodative credit solutions, increasingly, retail venues are also looking for detailed access to pre and post trade data and analysis, says Alexander. “This has heightened the need for transparent and detailed total cost-of-trade analysis. Providing clients readily actionable insights into the impact of their trading or hedging has become a new frontier in PoP service competition.”

It is here that the stratification of the PoP market becomes most stark, says Alexander. “Many PoPs are not as focused or aligned with their clients in wanting to provide such detailed analysis. Invast Global is of the belief that a PoPs services involves a partnership, more than simply a pass-through venue for linking liquidity and providing credit. A PoP should be actively focused on minimising the cost of trading and hedging for the venues they serve by leveraging the best pricing and execution and combining this with detailed transaction costs analysis (TCA) and broader contextual advice on liquidity and flow optimisation.”

A PoP should play an active role in serving customers’ exchange data needs and fulfil a ‘vendor of record’ role to numerous equities and futures exchanges, alongside tailored OTC pricing for FX & Metals,” says Alexander. “Many PoPs have rapidly become the largest redistributors of exchange data globally.”

The PoP market has proved to be largely resilient during the recent Covid-19 pandemic

A number of PoPs have also looked to make improvements across their liquidity and risk management operations. “To improve liquidity management, the more technology-focused PoPs have increasingly been automating liquidity management workflows,” says Alexander. “Such processes dynamically adjust liquidity in response to changing customer flow profiles. This is proving to be particularly important for managing bank and non-bank liquidity providers and a breakthrough for PoPs that often cater for a wide range of flow profiles within a single infrastructure stack. The changing of liquidity mix in response to client flow profiles has traditionally been done after the fact and is often subject to time lag. With new technology becoming available to the PoP sector, there has been a concerted push towards real time responsiveness to customer order flow, which best aligns the liquidity mix to the client flow profile.”

Meanwhile, Natallia Hunik, Chief Revenue Officer at Advanced Markets Group notes an increase in liquidity recycling. “I would not say that there has been a dramatic increase in the FX PoP space. I think that what we have been observing is more related to liquidity recycling in the industry, where Tier2 brokers are exchanging liquidity amongst themselves, a trend ultimately driven by a lack of access to Tier1 Prime Brokerage and a desire to better monetize their retail flow. 2021 has been different than 2020 with clients increasingly looking for access to multiple asset classes, and all via a single API pipe”, she says. “So Prime of Primes are challenged with providing the same quality of execution, pricing and institutional access for multiple access classes, which means handling more load, both transactional and pricing.”

“The biggest evolution I’ve seen in the region has been the way governments are stepping up to regulate the markets,”

Mohammed Isbeer

Diffusing risk

One development in the evolution of the PoPs sector is that they are in many ways making the market safer and more robust by helping to diffuse risk. “PoPs fulfil a vital role in the dispersion of counter-party risk at the Prime Broker venues that actively serve the FX market, while also ensuring appropriate access to credit that is increasingly being demanded by the retail venues served by PoPs,” says Alexander. “Without the PoP layer, there would almost certainly be a split amongst retail trading venues and smaller hedge funds into two segments, those large and sophisticated entities that can access a tier 1 prime broker, and those who cannot.”

“For those who can, they often find themselves underserved. Access to bespoke liquidity, execution technologies, reporting and credit, can be sub-optimal. For those that can’t access the Tier 1 PBs due to balance sheet or commercial constraints, PoPs represent an important source of credit that allows them to manage their own flows and exposures in a more appropriate manner. For the PoPs, this aggregation of smaller clients represents a diversified counterparty risk to the PoP and also ensures that they can be a meaningful partner to their prime broking relationships,” says Alexander.

“I think that what we have been observing is more related to liquidity recycling in the industry, where Tier2 brokers are exchanging liquidity amongst themselves, a trend ultimately driven by a lack of access to Tier1 Prime Brokerage and a desire to better monetize their retail flow.”

Natallia Hunik

“The top tier PoPs go one step further in mitigating risk via adhering to principles of best practice. One example of this is sourcing liquidity only from FX GCC signatories, whereby the counterparties are more open about and committed to best practices across pricing and execution. Forming relationships with these counterparties has very practical risk mitigating effects for all stakeholders, be they client, PoP, liquidity provider (LP) or prime broker,” says Alexander.
As stated, the pandemic has seen the PoP market grow exponentially, not just in FX but across many asset classes. “Broadly, PoP providers have performed exceptionally well over the last 18 months due in large part, to the heightened volatility that has driven up volumes within retail trading venues,” says Alexander. “The occurrence of WTI Oil going negative in Q1 2020 is an example of how risk management processes among PoPs have withstood some of the most challenging circumstances seen in the markets for many years. Overall, it has been a very positive year for the PoP segment and as we move into a landscape where interest rates rise above zero globally, heightened volatility should continue to be a positive driver for PoPs,” he adds.

Nevertheless, there are some potential future threats facing the market. For example, ongoing regulatory change is one thing that is closely monitored by PoPs, says Alexander. “As regulators globally enhance their oversight and regulation of trading venues, this will both evolve and refine the global trading landscape. PoPs with strong balance sheets, that represent stable counterparties will be well placed to benefit from this.”

There is also a question around PoPs ongoing appetite to provide credit to certain segments of the market, says Alexander. “The Credit Suisse/Archegos example is no doubt still a valid and relevant conversation amongst all Tier 1 prime brokers when it comes to counterparty assessment, with risk teams at Tier 1 Prime brokers consistently reviewing the ongoing viability of relationships based upon risk / reward metrics. Again, this speaks to the stratification and the diverse outcomes for various PoPs. The best PoPs will have access to increasing amounts of credit and those that fall below the agreed commercial or risk thresholds will find themselves challenged in accessing the same credit from Tier 1 prime brokers.”

Credit is a big driver of competition amongst PoPs

Future opportunity lies in the application of increasingly sophisticated technologies that will allow PoPs to better manage credit across their own customer bases as well as prime brokers, says Alexander. “Enhancements in technology on the clearing side will allow PoPs to utilise available NOPs more efficiently, better manage risk and maintain strong commercial outcomes for both PoP and prime broker. With multi asset services being offered by PoPs, there is a far broader opportunity for collateral optimisation amongst their client base than has been previously available under FX only PoP solutions,” he states. “The net effect of this is to both diversify the risk of any single counterparty to the PoP and also allow for a more efficient use of capital by the PoP across their prime broking network.”

Natalia Hunik also points out the safeguards that Prime of Primes can provide and the confidence that trading firms get from using them to help overcome liquidity constraints during difficult trading conditions. “True Prime of Primes provide somewhat of a safeguard, preventing the market from over-exposing. We provide the industry with access to multi-asset institutional pricing, and execution, at the times when it needs it most. Many market players find out about liquidity limitations only at the liquidity crunch event where their single source of liquidity pulls the pricing. Using a Prime of Prime solution gives access to primary FX liquidity (banks, money centers, hedge funds, institutional market makers and others) and the confidence that you will always have a functioning execution outlet when markets get volatile”, she says.

Better technology

Another reason that the global FX PoP market has increased significantly recently is that tier one prime brokers are being selective in terms of the institutions they work with, says Justin Boulton, head of FX prime broking at FXCM. “They want multi-asset clients, not just those with spot FX needs. Following the recent Archegos collapse, they have also tightened existing lending terms and in some cases, terminated access for small to middle sized non-banking financial institutions to minimise the credit risk they were exposed to. This means there are more institutions with significant volume looking for alternatives to tier one prime brokers.”

This is not necessarily a new development. A more selective approach from prime brokers towards their clientele was what created the PoP market in the first place. However, says Boulton, new and better technology means that these firms can continue to receive the same quality of service from PoPs with no material impact on their trading. “This makes PoP, when done properly, a more attractive offering to a broader client base,” says Boulton.

“A lot of new players are entering the market because PoP offers a significant return on capital and a stable revenue stream.”

Mohammad Isbeer

Clients are looking for a quick, professional and proactive service with as much access to institutional venues and counterparties as possible, says Boulton. “The best PoP solutions replicate tier one prime brokerage relationships by offering just this, with pure direct market access and the ability to clear their clients’ trades. They also offer reliable and proven technology, such as robust pre- and post-trade technology with transaction cost analysis, aggregation and distribution where required.”

Risk management is also a critical consideration for the leading PoPs, says Boulton. “FXCM has always had a very robust risk management emphasis. We have always insisted on a pre-trade credit check on all of our clients which not only protects our business, but also allows our clients to trade across 30 venues and counterparties under a single net open position (NOP) with no credit ‘log-jams’. We also offer an extremely quick and frictionless onboarding process, completing know your customer (KYC) and all other checks within a matter of weeks, rather than the six to nine months it can take to get on-boarded by a tier one prime broker,” says Boulton.

Boulton also agrees that the PoP market has proved to be largely resilient during the recent Covid-19 pandemic and this has ultimately helped to attract more clients. “The Covid-19 pandemic, especially during the extreme volatility at the start of the pandemic, was a very robust stress test of our systems, including pre-trade and back-office processes and client services. We passed this very serious test and actually executed record volumes and numbers of trades across all 30+ venues we offer with no major issues.”

While Hunik says that, “Most Prime of Prime providers thrived during the Covid-19 pandemic due to the increased transactional volume that resulted from increased volatility.”

In terms of future threats and opportunities for the FX PoP market, these centre on the growing demand for more asset classes but also the lack of volatility, says Boulton. “As tier ones continue to tighten their terms and terminate relationships with smaller clients, the market for PoPs which offer a similar service grows. There are also opportunities to be had in other FX products such as non-deliverable forwards (NDFs) and swaps, as well as other asset classes as demand grows and technology develops. The current threat, not just to PoPs but all FX participants, is the extreme lack of volatility and movement in the FX market. However, as history shows, the FX market doesn’t stay calm forever.”

A lucrative market

Part of the reason that so many new players are entering the PoP market is because of the attractive economics and the prospect of financial reward, says Mohammad Isbeer, global head of brokerage at prime broker Equiti Group. “A lot of new players are entering the market because PoP offers a significant return on capital and a stable revenue stream. The market did well during Covid and that has also attracted more newcomers – it has been a lucrative and reliable market and that has helped companies raise capital and secure backing to enter the market,” says Isbeer.

The PoP sector originally grew to fill a gap in the market that resulted from prime brokers becoming more circumspect about their counterparties. In that original model, the PoP was a broker with access to tier 1 capital that was able to offer access to other tier 1 banks. But, as the PoP market has grown, so has the definition of what makes a PoP, says Isbeer. “We are now seeing PoPs and their clients coming from tier 2 banks and brokers,” he says. This is not a major concern in terms of risk management and creditworthiness, says Isbeer, provided that there is transparency. “These new PoPs are filling a genuine gap in the market,” he says.

The demands placed upon PoPs have not fundamentally changed, says Isbeer, however there is now a much greater emphasis on providing a bespoke service. “The first thing is the provision of capital. That is the essence of the B2B market and the primary reason that a broker comes to a PoP- they don’t have enough capital so the first step is to expand their balance sheet. Clients are looking for quality of spreads and execution. But customisation is key. There is no more one-size-fits-all. The flow from retail brokers is changing and is often too big to be handled by other retail brokers. But as a PoP you need to be able to customise your liquidity management to handle its size and variety,” says Isbeer.

Isbeer says that a PoP needs between 15-20 different liquidity pools to provide adequate customisation and to cater for a growing number of asset classes. “It is not just FX anymore but CFDs, cryptocurrencies, fractional shares. Crypto is a big trend in retail market at the moment and retail brokers want to cater for that but we are still in the early stages and there is a gap in the market there that needs to be filled. It is a major opportunity.”

Another development among the leading PoPs has been the provision of risk management tools such as auto-hedging, says Isbeer. “Traditional brokers run a business book and internalise it, so PoPs have spent money on payment and order flow by adopting risk management tools that internalise that flow before passing it back to the street. It is about using auto-hedging tools rather than ‘b-booking’. It was led by the large hedge funds but has become a more widely adopted practice now because the tools and expertise are more accessible.”

By offering this service to brokers that do not have the resources to do it themselves, PoPs are helping to improve risk management in the market, says Isbeer. “It is the reason the PoP market was created, to make the market safer. A PoP may not be as secure as the PB market but it filled a gap that made it possible for retail brokers to make a profit without having to assume as much risk.”

This ability to make the market safer was demonstrated during the early stages of the Covid-19 pandemic which increased volatility all over the world and created more volume for retail brokers. But as those brokers reached the limits of their capacity, it created much more demand for PoPs as well as primes and prime brokers, says Isbeer. This in turn resulted in hedge funds looking at the market and investing in order to back the PoPs. And Isbeer is confident that the interest in the PoP market will endure once the pandemic recedes.

“The wave of volatility from Covid may have ended but we have not seen the volume or the investment fall away,” he says. “There is maybe not the same level of growth but we are seeing interest in new asset classes like crypto create new sources of volume. During the lockdown there was more education about crypto and new digital asset classes and instruments. I think we are only at the beginning of this trend. Online trading is everywhere now and the PoP industry was well positioned to capitalise on this trend through the Covid crisis and beyond.”